Clear Eyed Capitalist

Archive for October, 2009

I have an SRI fund manager that I really love, and nearly a decade of experience with them and good performance. I spoke recently to a consultant about them and he was having trouble getting excited. He admitted there was nothing he would really ding them for but that they didn’t float to the top of his column. As I later pondered his general concerns with a friend she came up with the phrase “repeatable process”. That really sounded like a good capture of his concerns for me, and a logical thing he might be looking for. Certainly as an investor looking at companies I want to see repeatable process – in a startup there needs to be at least a few, because growing a company is all about designing and re-designing repeatable processes.

In selecting a fund manager it makes sense to do the same thing – look for repeatable process, but I found myself thinking that SRI shops that’s probably less likely. Sustainable and Responsible Investing (following the lead of Calvert following the lead of Good Funds in renaming Socially Responsible Investing) is about investing in companies and transactions that bring people back into processes. It makes sense to me that the investment funds and managers themselves would be the same way. I could make an argument that it brings more risk into the equation, but I will instead argue that it brings more thinking into the equation as well.

I use an investment advisor and one of their roles is to check up regularly on investment funds and follow up on personnel changes at fund management companies to respond if that change seems likely to impact future performance. It seems to me the advisor layer is perfect for mitigating any additional risk brought on by my funds using people instead of processes, allowing me (and the companies those managers analyze) to benefit from their creative and engaged thinking.

Standard investment advisor practice seems to instead be to focus on repeatable process – creating an unnecessary barrier to understanding, respecting and fully utilizing the value of SRI funds. Perhaps it minimizes the advisors workload but it reduces their value as well.

The general idea seems to be capital that is willing to wait longer to get a return. That implies to me that eventually, there will be a return, and perhaps further, that said return will be a respectable one. I’m thinking at least market rate for equities over that period of time, and so I would be choosing to do the patient capital thing because I get the satisfaction of pursuing a specific social good or I’m diversifying away from public equity.

I think sometimes “patient capital” represents a reaction against the classic venture portfolio model. That portfolio model is to invest in a series of potentially-high-return companies such that if one hits big it can cover the loss of all the others. In that model, the portfolio companies are pressured to grow very quickly. I’ve come to believe that the high-risk, high-return investment style may be a self-fulfilling prophecy – that growing big quickly IS riskier than growing slowly – there’s little time to orient added employees, develop a thoughtful employee culture, refine internal systems, or establish track records with suppliers, all of which increases the risk that the company will fail.

Is rapid growth really necessary except for rapid returns? Not every market is so competitive that it’s critical to leap to the fore. Network Effects (which create significant advantages for a single market leader) can be huge in new technology, but I’m not convinced they play a big factor in the specialty food industry. When Woody Tasch talks about the Slow Money movement, he’s talking about the idea that investors can instead invest in lower-risk, longer-to-return investments, and still come out as well because while you’re making less money per investment you’re also losing less money overall because fewer of your companies go under.

A challenge with these modest growth plans is that I don’t see how one can construct a self-replenishing investment fund with a time horizon of less than like 20 years. Capital will become captured in the permanent working capital of growing, healthy businesses who need to eventually switch to a “harvest” mode and begin paying out returns to release the original capital. Some community development type funds have had success in generating value (Renewal Partners and Pacific Community Ventures come to mind) but they also still have their initial funds tied up and have raised more money to invest in new ventures. How patient will that capital have to be to turn over? It’s as yet unanswered. To some extent, this is also the role of a bank – longer time horizons, unglamorous returns. But a bank can only step in once the business models are proven – the initial experimental capital has to come from somewhere else.

This gets to the capital in the middle – not philanthropy, not market-rate investing, but essentially grant capital to develop more socially desirable business models. The “investors” need to be conscious of the risk they’re taking so they are consciously spending these dollars this way – not every experiment will lead to an investable proposition, in fact most will probably not. So we’re back to the high-risk/ high-reward strategy, but as patient capitalists, without driving companies to try and be high-reward. We could try to build into the model “equity kickers” that allow the fund to capture the rare “pop” that will then pay for the R&D on all the ideas, but from I’m not convinced it could be self-replenishing: in which case it has to be treated more like grant dollars. We don’t have tax-advantaged models for doing this easily – L3Cs and PRIs will only go so far. Still I think investors with social goals need to explicitly make these grant-investments – you can’t get change without taking risks. Entrepreneurs and investors trying to do something never done before need to look to non-profit models for giving a social return – “donor” engagement, detailed reporting, social metrics.

One problem I see now is investors and entrepreneurs confusing the two types of social capital (experimental and patient): thinking there’s a good business plan to do something new and ignoring the risk involved with the unproven. Investors think they’re investing and entrepreneurs are overconfident about their initial model. Then the company is essentially recapitalized in round 2 or 3 once they manage to demonstrate a successful business model and its true worth can be assessed, if they make it that far.

Another problem is the failure to consistently pursue like-minded capital. A patient portfolio succeeds when investments are low-risk, and an aggressive portfolio succeeds because its investments are potentially high-return. Mixing those two styles of investors in one investment will not likely work for both – one group will be unhappy, and the entrepreneur will inevitably be unhappy too.

Net, we need more experimental capital, we need the social metrics to give that experimental capital at least a social return, and we need social entrepreneurs to focus on developing truly investable business propositions at minimal cost so we can keep social capital funds replenished.